A-LEVEL

Economics

Government Fiscal Policy

Fiscal policyinvolves the use ofgovernment spending, taxation and borrowingto affect the level and growth of aggregate demand, output and jobs

Fiscal policy is also used to change thepattern of spendingon goods and services

It is also a means by which a redistribution of income & wealth can be achieved

It is an instrument of intervention to correct for free-market failures

Changes in fiscal policy affectaggregate demand(AD)andaggregate supply(AS)

In the UK, the Treasury (pictured right) is in charge of fiscal policy decisions

Fiscal Policy and Aggregate Demand

Traditionally fiscal policy has been seen as aninstrument of demand management. This means that changes in government spending, direct and indirect taxation and the budget balance can be usedcounter-cyclicallyto help smooth out some of the volatility of national output particularly when the economy has experienced anexternal shockand is in a recession.

TheKeynesian schoolargues that fiscal policy can have powerful effects on demand, output and employment when the economy is operating below fullcapacitynational output, and where there is a need to provide ademand-stimulus.

Monetarist economistsbelieve that government spending and tax changes only have a temporary effect on aggregate demand, output and jobs and that the tools ofmonetary policyare a more effective instrument in controlling inflation and maintaining macroeconomic stability

The fiscal policy transmission mechanism

This flow-chart identifies some of the channels involved with the fiscal policy transmission mechanism in the example shown we focus on an expansionary fiscal policy designed to boost demand and output

Themultiplier effects of an expansionary fiscal policydepend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports. And also the effects of fiscal policy on variables such asinterest ratesAcontractionary fiscal policywould involve one or more of the following:

A cut in government expenditure either in real terms or as a share of GDP

An increase in direct and/or indirect taxes

An attempt to reduce the size of the budget deficit

Government spending

Government spending (or public spending) and in Britain, it takes up over 45% of GDP. Spending by the public sector can be broken down into three main areas:

Transfer Payments:

a. These arewelfare paymentsmade available through thesocial security systemincluding the Jobseekers Allowance, Child Benefit, State Pension, Student Grants, Housing Benefit, Income Support and the Working Families Tax Credit

b. The main aim of transfer payments is to provide abasic floor of incomeor minimum standard of living for low income households. And they allow the government to change the final distribution of income. In 2010-11 the UK government spent 196bn on welfare benefits, equivalent to 13.4% of GDP

Current Government Spending: i.e. spending onstate-provided goods & servicesthat are provided on a recurrent basis - for example salaries paid to people working in the NHS and resources for state education and defence. The NHS is the countrys biggest employer with over one million people working within the system!

Capital Spending: Capital spending includes infrastructure spending such as new motorways and roads, hospitals, schools and prisons. This investment spending adds to the economys capital stock and can have important demand and supply side effects in the long term.

The main items of UK government spending are shown in the pie chart below- the data is taken from the March 2011 UK Budget Statement available from the HM Treasury website.Social protectionis the biggest single component of departmental spending and includes the many welfare benefits paid to recipients including the state pension, the jobseekers allowance, income support and housing benefit.

Economic and Social Justifications for Government Spending To provide a socially efficient level ofpublic goods and merit goodsand overcome market failure

a. Public goods and merit goods tend to be under-provided by the private sector

b. Improved and affordable access to education, health, housing and other public services can help to improve human capital, raise productivity and generate gains for society as a whole

To provide asafety-net system of welfare benefitsto supplement the incomes of the poorest in society this is also part of theprocess of redistributing income andwealth. Government spending has an important role to play in controlling / reducing the level of relative poverty

To providenecessary infrastructurevia capital spending on transport, education and health facilities an important component of a countrys long runaggregate supply Government spending can be used tomanage the level and growth of ADto meet macroeconomic policy objectives such as low inflation and higher levels of employment

Government spending can be justified as a way of promoting equity. Well targeted and high value for money public spending is also a catalyst for improving economic efficiency and macro performance.

Taxation

Direct taxationis levied onincome, wealth and profit. Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax.

Indirect taxesare taxes on spending such as excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services

What are the main sources of tax revenues for the UK government?The table below shows the annual revenue from the main taxes in the UK.

Category of TaxTax Revenue in 2010-11

Income tax153.3

National insurance contributions97.7

Value added tax86.3

Corporation tax43.0

Fuel duties27.3

Council tax25.7

Business rates23.3

Tobacco duties9.1

Stamp duty land tax6.0

Vehicle excise duties5.8

Beer and cider duties3.7

Capital gains tax3.6

Source: Office for Budgetary Responsibility, March 2012

Progressive, proportional and regressive taxes and the distribution of income With aprogressive tax,the marginal rate of tax rises as income rises. I.e. as people earn more income, the rate of tax on each extra pound goes up. This causes a rise in the average rate of tax

With aproportional tax, the marginal rate of tax is constant. National insurance contributions are the closest example in the UK of a proportional tax, although low-income earners do not pay NICs below an income threshold

With aregressive tax, the rate of tax falls as incomes rise I.e. the average rate of tax is lower for people of higher incomes. In the UK, regressive taxes come from excise duties of items of spending such as cigarettes and alcohol. Indirect taxes form a larger percentage of the disposable income of those who earn less, even though they may also spend less

Income TaxIncome tax in the UK isprogressive here are the current tax rates(correct to the end of 2011) Most people have a tax free personal allowance worth 7,475 (up to an annual income of 100,000)

Basic rate of income tax = 20% on incomes up to 37,000

Higher rate of income tax = 40%

A top rate of 50% applies to income over 150,000

As income rises, the rate of tax rises so that people on the highest incomes will pay a higher percentage of their income to the government. The progressivity of the income tax system for the UK is shown in the table below. People with an annual income greater than 1 million will pay a tax rate of over 44%.

Corporation TaxThis is a tax on business profits. There is a tax free allowance for businesses making low annual profits

Small Profits Rate (for businesses with profits < 300,000) = 20%

Main rate of Corporation Tax = 25%

Value Added Tax (VAT)Value Added Tax (VAT) is a tax that's charged on most goods and services that VAT-registered businesses provide in the UK. It's also charged on goods and some services that are imported from countries outside the European Union (EU), and brought into the UK from other EU countries

There are three rates of VAT, depending on the goods or services the business provides. The rates are:

Standard - 20 per cent

Reduced - 5 per cent i.e. energy bills

Zero - 0 per cent (i.e. exempt) including childrens clothes, congestion charge, doctors fees

Automatic stabilisers and discretionary changes in fiscal policyDiscretionary fiscal changesaredeliberate changesin direct and indirect taxation and govt spending for example, increased capital spending on roads or more resources going into the NHS.

Automatic stabilisersare changes in tax revenues and government spending that come about automatically as an economy moves through the business cycle

Tax revenues:When the economy is expanding rapidly the amount of tax revenue increases which takes money out of the circular flow of income and spending

Welfare spending:A growing economy means that the government does not have to spend as much on means-tested welfare benefits such as income support and unemployment benefits

Budget balance and the circular flow:A fast-growing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a largerbudget deficit.

Fiscal Policy andAggregate SupplyIt is important to understand that fiscal policy can have important effects on thesupply-side of the economy. Indeed many government fiscal decisions are made with improving the supply-side in mind.

The current Coalition government has launched aGrowth Review a set of policies that aims to drive stronger GDP growth in the UK as the economy struggles to emerge from the recession. Many of their aims require the active use of fiscal policy to boost supply-side incentives, investment and efficiency.

Labour market incentives:a. Changes in income tax can improve incentives for people to actively look for work

b. Lower taxes might also have a positive effect on work effort and labour productivity

c. Cuts to national insurance contributions might help to expand the active labour supply

d. Some economists argue thatwelfare benefit reformsare more important than tax cuts in improving incentives to create a gap between the incomes of people in a job and the unemployed. Some people favour reducing the relative value of benefits as a way of improving incentives. Others favour a move towards targeted benefits where the transfer payment is linked to participation in employment schemes or community work

Capital spending:

a. Spending oninfrastructure(e.g. improvements to our motorway network or an increase in the building programme for new schools and hospitals) helps provide the capacity needed for other businesses to flourish.

b. Lower rates of corporation tax and other business taxes might attract inward investment from overseas. An aim of the UK government is to have the lowest corporate tax rate in the G7 and among the lowest in the G20 nations Entrepreneurship and investment:

a. Government spending can be used to fund an expansion in new small business start-ups

Research and development andinnovation:

a. Government spending, tax credits and other tax allowances could be used to encourage research and development to improve competitiveness and contribute to a faster pace of innovation and invention

b. A key aim going forward is to use tax incentives to stimulate an increase in investment in low carbon technologies to promote green growth

Human capitalof the workforce:

a. Spending on education and increased investment in health and transport can also have important supply-side effects in the long run

b. Government spending on youth apprenticeships can help to improve human capital, employability and productivity giving more younger people the chance to make a strong start when they enter the labour market

The Free Market AgendaFree market economistsare sceptical of the effects of government spending in improving the supply-side of the economy. They argue that lower taxation and tight control of government spending and borrowing is required to allow the private sector of the economy to flourish. They believe in a smaller sized state sector so that in the long run, the overall burden of taxation can come down and thus allow the private sector of the economy to grow and flourish.

Economics of a Budget (Fiscal) Deficit When the government is running abudget deficit, it means that in a given year, total government expenditure exceeds total tax revenue

If the government is running a budget deficit, it has to borrow this money through the issue of debt such as Treasury bills and bonds

Most of the government debt is bought up by financial institutions but individuals can buy bonds, premium bonds and buy national savings certificates

The budget balance is the annual difference between tax revenues and government spending

Gross government debt is the total accumulated debt owed by the government this is also known as the national debt

The UK government last had a budget surplus in the year 2000 but it has run budget deficits in every year since then.

There was a large rise in the budget deficit from 2008 onwards because of the recession and also attempts by the government to stimulate the economy. The deficit peaked at over 10% of GDP and been declining gradually since.

Does a budget deficit matter?A persistently largebudget deficitcan be a problem:

Financing a deficit:a. If the budget deficit rises to a high level, the government may have to offer higher interest rates to attract sufficient buyers of debt.

b. This raises the possibility of the government falling into adebt trapwhere it must borrow more to repay the interest on accumulated borrowing.

c. Many high debt countries in the European Union have suffered from this in recent years high profile examples have included Ireland, Greece, Spain and Portugal.

A government debt mountain:a. Annual budget deficits over a number of years will cause the total amount of unpaid government debt to climb.

b. There is anopportunity costinvolved because interest payments on bonds might be used in more productive ways, for example on health services or extra investment in education. Every 0.05% saved on 220bn of new debt pays one years salary for 46,000 teachers.

c. Higher public sector debt also represents atransfer of incomefrom people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy.

Crowding-out:a. If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has a negative effect on growth in consumption and investment spending, then a process of fiscal crowding-outis occurring

b. The Institute of Fiscal Studies has estimated that reducing the UK budget deficit over the next five years will require every person in the UK to pay 1250 of extra taxes each year.

Risk of capital flight:

a. Some economists believe that high borrowing risks causing a run on a domestic currency. This is because the government may find it difficult to find sufficient buyers of its debt and the credit-rating agencies may decide to reduce the rating on a nations sovereign debt

Potential benefits of a budget deficit1. Government borrowing can benefit growth:a. A budget deficit can have positive macroeconomic effects if it is used to finance capital spending that leads to an increase in thestock of national assetsb. For example, spending on transportinfrastructureimproves thesupply-side capacity and productivity of the economyc. Improved provision of public goods can create positive externalities

2. The budget deficit as a tool of demand management:a. Keynesian economists support borrowing as a way of managingaggregate demandb. An increase in borrowing can be auseful stimulus to demandwhen other sectors of the economy are suffering from weak or falling spending

c. A change in the government budget deficit may lead to a more than proportional change in aggregate demand this is known as thefiscal multiplier effect.

Cutting the deficit the Coalition policies The Coalition Government wants to halve the budget deficit over a five year period

They have launched a programme offiscal austerityamounting to 126 billion a year of combined spending cuts and tax rises

Most of the fiscal austerity is coming through planned reductions in the real level of government spending. 80% will come from spending reductions, 20% is forecast to come from higher taxes

The fiscal squeeze is highly controversial and has led to an impassioned debate among economists about the best way to control a budget deficit as an economy struggles to lift itself out of recession and sustain a recovery.

Keynesian economistsargue that deficit-reduction policies risk driving the economy into a second recession known as adouble-dip. Reducing spending or raising taxes could hurt an already fragile economy and make the fiscal deficit problem even worse. They doubt whether new job creation in the private sector is likely to be able to compensate for job losses in the public sector.

Keynesians believe that economic growth will help bring down the deficit and that maintaining a sufficiently high level of demand is crucial to achieving this public expenditure is a component of aggregate demand and hence if public expenditure falls so will aggregate demand C+I+G+X-M). Many private sector jobs depend on public sector spending, for example workers in the construction industry who build new roads or social housing.

The government believes that reducing the budget deficit is possible without causing another downturn and that cutting the budget deficit is important to maintain their economic credibility in financial markets. Cuts in public spending are unavoidable given the size of the budget deficit. Their strategy relies less heavily on tax increases; indeed some taxes have been cut in a bid to stimulate private sector investment

Monetary Policy Monetary policyinfluences the decisions that we make about how much we save, borrow and spend

Decisions made by the central banks that operate monetary policy can have a powerful effect on consumers and businesses

Changes in interest rates have both demand and supply-side effects.

What is Money?

Money is any asset that is acceptable as a medium of exchange in payment for goods and services. The functions of money are as follows:

Amedium of exchangeused in payment for goods and services

Aunit of accountused to relative measure prices and draw up accounts

Astandard of deferred payment for example when using credit to purchase goods and services now but pay for them later

Astore of value- money holds its value unless there is a situation of accelerating inflation. As the general price level rises, so the internal value of a unit of currency decreases.

Interest Rates

The media often talks about interest rates going up, or interest rates going doing as if there was one single or unique rate of interest in the economy. That isnt true indeed there are thousands of different rates in the financial markets it can get confusing!

For example we distinguish betweensavings ratesandborrowing rates, interest rates on secured and unsecured loans and short term and long term interest rates on different forms of savings account.

However we find that interest rates tend to move in the same direction. For example if theBank of Englandcuts the base rate of interest then we expect to see commercial banks cutting the rates on their loans and lower rates are offered on savings accounts with Banks and Building Societies.

The Real Rate of Interest

Thereal rate of interestis important to businesses and consumers when making spending and saving decisions

The real rate of return on savings, for example, is the money rate of interest minus the rate of inflation. So if a saver is receiving a money rate of interest of 6% on his savings, but price inflation is running at 3% per year, the real rate of return on these savings is only + 3%.

Real interest rates become negative when the nominal rate of interest is less than inflation, for example if inflation is 5% and nominal interest rates are 4%, the real cost of borrowing money is negative at -1%.

The Bank of England and the operation of Monetary Policy

Founded in 1694, nationalized in 1946, the Bank of England is charged with providing monetary and financial stability for the United Kingdom

TheBank of Englandhas been independent since 1997

The Monetary Policy Committee (MPC) has nine members, some of whom are appointed by the government and some by the Bank of England. The Governor of the Bank has the casting vote if there is an equally split decision on interest rates

Each month the MPC meets to consider the latest news on the UK and global economy

Their job is to make a judgement on what is the appropriate level of base interest rates for theUK economyconsistent with the need to meet aninflation targetset by the government

That inflation target isconsumer price inflationof 2%

The MPC has one eye on maintaining growth (although a set rate of GDP growth isnotpart of their target). Inflation is allowed to vary by 1% either side of the 2% target so they have some leeway.

Official UK interest rates in recent years

Factors considered when setting interest rates

At each of their rate-setting meetings, the members of the MPC consider a huge amount of information on the state of the economy. Here are some of the factors they consider when making rate decisions.

GDP growth and sparecapacity: The rate of growth of GDP and the size of theoutput gap. Their main task is to set monetary policy so that AD grows in line with productive potential.

Bank lending and consumer credit figures- including the levels of equity withdrawal from the housing market and also data on credit card lending which supports consumer demand

Equity markets (share prices) andhouse prices- both are considered important in determining household wealth, which then feeds through to borrowing and retail spending. The monetary policy committee has no official target for the annual rate ofhouse price inflationbut it has been criticized for not doing enough to prevent the housing bubble in Britain up to 2008.

Consumer confidenceand business confidence confidence surveys can provide advance warning of turning points in the economic cycle. These are called leading indicators.

Growth of wages, average earnings and unit labour costs- wage inflation might be a cause of cost-push inflation so the Bank of England looks carefully at what is happening to wages

Unemployment figures- and survey evidence on the scale of shortages of skilled labour.

Trends in global foreign exchange markets a weaker exchange rate could be seen as a threat to inflation because it raises the prices of imported goods and services. A strong exchange rate might bring down inflation but risk causing a deeper economic slowdown via a fall in exports

International data- including recent developments in the Euro Zone, emerging market countries and the United States and Japan.

The key point is that the Monetary Policy Committee considers many indicators from both the demand and the supply-side of the economy.They then have to make a judgement about what this evidence says aboutinflationary pressuresover a two year forecast horizon.Why do they have to look up to two years ahead? Because when interest rates are changed, it takes time for them to have an effect on aggregate demand and prices. Uncertain time lags in a world of many external economic shocks make the handling of monetary policy a difficult job!

What are the main effects of changes in interest rates?

Before we look at the impact of rate changes, it is worth remembering that when the Bank is making a decision, there will be lots of other events and policy decisions being made elsewhere in the economy, for example changes in fiscal policy by the government, or perhaps a change in world oil prices or the exchange rate. In macroeconomics theceteris paribusassumption (all other factors held equal) rarely applies! There are several ways in which changes in interest rates influence aggregate demand, output and prices. These are collectively known as thetransmission mechanism of monetary policy

One of the channels that the Monetary Policy Committee in the UK can use to influence aggregate demand, and inflation, is via thelending and borrowing ratescharged in the financial markets.

When the Banks own base interest rate goes up, then commercial banks and building societies will typically increase how much they charge on loans and the interest that they offer on savings.

This tends to discourage businesses from taking out loans to finance investment and encourages the consumer to save rather than spend and so depresses aggregate demand

Conversely, when the base rate falls, banks cut the market rates offered on loans and savings and the effect ought to be a stimulus to demand and output.

A key influence played by interest rate changes is the effect onconfidence in particular households confidence about their own personal financial circumstances.

Changes in interest rates affect:

Housing market & house prices:

a. Higher interest rates increase the cost of mortgages and reduce the demand for most types of housing. This will affect householdwealthand put a squeeze onequity withdrawal(where consumers borrow money secured on rising house prices) which adds directly to consumer spending.

Effective disposable incomes of mortgage payers:

a. If interest rates increase, the income of homeowners who have variable-rate mortgages will fall leading to a decline in their effective purchasing power

b. The effects of a rate change are greater when the level of existing mortgage debt is high as this makes property owners more exposed to higher costs of repaying debts.

Disposable income of savers:

a. A rise in interest rates boosts the disposable income of people who have paid off their mortgage and who have positive net savings in bank and building society accounts

b. But if the rate of interest is lower than the rate of inflation, then the annual real return on saving will be negative.

Consumer demand for credit:

a. Higher interest rates increase the cost of paying the debt on credit cards and should lead to a deceleration in retail sales and spending on consumer durables especially items such as cars and household appliances which are typically bought on credit.

Businesscapital investment:

a. Firms often take the actual and expected level of interest rates into account when deciding whether or not to go ahead with new capital investment spending

b. A rise in interest rates may dampenconfidenceand lead to a reduction in planned capital investment. However, many factors influence investment decisions other than rate changes.

Consumer and business confidence:

a. The relationship between interest rates and business and consumer confidence is complex, and depends crucially on prevailing economic conditions

b. For example, when businesses and consumers are worried about the recession, an interest rate cut can boost confidence because it reassures the public that the Bank is alert to the dangers of a slump

c. Some people might take emergency interest rate cuts as a sign that the wider economy is in difficulty and hard times lie ahead.

Interest rates and theexchange rate:

a. The link between interest rates and movements in the external value of a currency are important to understand at AS level.

b. Higher UK interest rates might lead to an appreciation of the exchange rate particularly if UK interest rates rise relative to those in the Euro Zone and the United States attracting inflows ofhot moneyinto the British banking system.

c. A stronger exchange rate reduces the competitiveness of UKexportsin overseas markets because it makes our exports appear more expensive when priced in a foreign currency leading to a decline in export volumes and market share.

d. It also reduces the sterling price of imported goods and services leading to lower prices and rising import penetration. If thetrade deficitin goods and services widens, this is a net withdrawal of demand from the circular flow and acts to reduce excess demand in the economy.

Key points:

A reduction in interest rates and/or an increase in the supply of money and credit in an economy is called an expansionary monetary policy or a reflationary monetary policy

An increase in interest rates and/or attempts to control or reduce the supply of money and credit is called a contractionary monetary policy or a deflationary monetary policy

Over the last few decades, monetary policy has been the main policy instrument for managing the level and rate of growth of aggregate demand and inflationary pressures

Monetary Policy Asymmetry

Fluctuations in interest rates do not have a uniform impact on the economy. Some industries are more affected by interest rate changes than others, for example exporters and industries connected to the housing market. And, some regions are also more sensitive to a change in the direction of interest rates.

The markets and businesses most affected by changes in interest rates are those wheredemand is interest elasticin other words, demand responds elastically to a change in interest rates or indirectly through changes in the exchange rate

Good examples ofinterest-sensitive industriesinclude those directly linked to the housing market exporters of manufactured goods, the construction industry and leisure services

In contrast, the demand for basic foods and utilities is less affected by short term fluctuations in interest rates and is affected more by changes in commodity prices such asoil and gas.

Ultra low interest rates in the UK from 2009-2012

The Bank of England started cutting monetary policy interest rates in the autumn of 2008 as thecredit crunchwas starting to bite and business and consumer confidence was taking a huge hit. By the start of 2009 rates were down to 3% and they carried on falling

By the summer of 2009 the policy interest rate in the UK was 0.5% and theBank of Englandhad reached the point of no return when it comes to cutting interest rates

The decision to reduce official base rates to their minimum was in response to evidence of a deepening recession and fears of price deflation

Ultra-low interest rates are an example of an expansionary monetary policy i.e. a policy designed to deliberately boost aggregate demand and output. At the time of writing (August 2012) official base interest rates have stayed at 0.5% for over two and a half years and there are few signs that they will increase significantly in the near term.

In theory cutting interest rates close to zero provides a big monetary stimulus this means that:

Mortgage payers have less interest to pay increasing their effective disposable income

Cheaper loans should provide a possible floor for house prices in the property market

Businesses will be under less pressure to meet interest payments on their loans

The cost of consumer credit should fall encouraging the purchase of big-ticket items such as a new car or kitchen

Lower interest rates might cause a depreciation of sterling thereby boosting thecompetitivenessof the export sector

Lower rates are designed to boost consumer and businessconfidenceBut some analysts argue that in current circumstances, a period of low interest rates has little impact on demand. Several reasons have been put forward for this:

The unwillingness of banks to lend most banks have become risk-averse and they have cut the size of their loan books and making credit harder to obtain

Low consumer confidence people are not prepared to commit to major purchases because the recession has made people risk averse. Weak expectations lower the effect of rate changes on consumer demand i.e. there is a low interest elasticity of demand.

Huge levels of debt still need to be paid off including over 200bn on credit cards

Falling or slowing rise asset prices makes it unlikely that cheap mortgages will provide an immediate boost to the housing market.

Although official monetary policy interest rates are now close to zero, the rate of interest charged on loans and overdrafts has actually increased the cost of borrowing using credit cards and bank loans is a high multiple of the policy rate. Little wonder that many smaller businesses have complained that the Bank of Englands policy of cheap money has done little to improve their situation during the recession and in the early stages of the recovery.

In March 2009 the Bank of England started a policy ofquantitative easing(QE) for the first time. QE is also called as asset purchase scheme or a bond purchase scheme

The aim of QE is to support demand in the economy and prevent a period when inflation is persistently below target or becomes negative (deflation).

The Bank of England can use QE to increase thesupply of money in the banking system.

The media call this printing money but this is only true in an electronic sense the Bank does not actually print new 10, 20 and 50 notes in an attempt to inject cash into the economic system.

Under thisunconventional strategy, the MPC discusses each month how manyassets, including government bonds, to buy with central bank money. This money is simply created by the central bank and is the equivalent of turning on the printing press.

Quantitative easing has been used by other central banks including the USA Federal Reserve

There are doubts about the effectiveness of quantitative easing bank lending has struggled to recover since the end of the recession despite bond purchases totalling 375bn as of July 2012

Funding for Lending Scheme (FLS)

This was introduced in 2012 as a new policy designed to increase the supply of credit in the British economy. The FLS offers banks and other lenders cheap funding (lower interest rates) secured against some of their assets (known as collateral) if they agree to lend on to businesses and home-buyers.

Some Evaluation Points on Interest Rates

Time lagsshould always be considered when analyzing the effects of interest rate changes.

Monetary policy is not an exact science what happens in the macro-economy is the result of millions of decisions taken by households and businesses. We cannot predict with great accuracy the extent to which a change in interest rates will achieved the desired / planned economic effects

When it comes to inflation targeting there aremany factors affecting costs and pricesand most of these are outside of the Bank of Englands direct control e.g. changes in international commodity prices and fluctuations in the exchange rate (see the next chapter)

Monetary policydoes not work in isolation! Always remember consider how the governments fiscal policy is affecting demand and inflationary pressures.

Changes in interest rates can have an important effect on thedistribution of income and wealthin a country. This is discussed briefly below:

Interest rates and the distribution of income and wealth

Consider the effect of a fall in interest rates throughout an economy

The real income of savers:

If the rate of interest paid on savings falls below the rate of inflation, then people with positive net savings will see a reduction in their real incomes

This has become a major policy issue in recent years with interest rates on deposit accounts collapsing in the UK. Rising inflation and falling interest rates have dealt a double-blow to millions of savers many of whom are older and reliant on savings as a source of income. The return is even lower when we consider that most savers pay 20% tax on any interest. Some pay 40% or 50% on their savings interest.

The disposable incomes of mortgage-payers:

If interest rates fall, the income of home-owners who have variable-rate mortgages will increase leading to an rise in their purchasing power

Interest rates, house prices and wealth:

Many factors affect house prices but when the cost of a mortgage falls, standard theory predicts that the demand for housing will expand driving property values higher.

This increases the net financial wealth of people who own property but makes it more difficult for lower-income families including many young people to find the money to afford to purchase a house or flat.

In summary - when interest rates fall, there is are-distribution of incomeaway from lenders (who receive less) towards those with variable rate loans.

People with positive net savings also stand to lose out from big cuts in interest rates. Little wonder that the Governor of the Bank of England gets many letters of complaints from pensioners when interest rates are cut or remain low for long periods of time!

Unemployment

Who is unemployed?

The unemployed are people able, available and willing to work at the going wage rate but cannot find a job despite anactive search for work

Unemployment means that scarce human resources are not being used to produce goods and services to meet peoples needs and wants

Persistently high levels of joblessness have damaging consequences for an economy causing both economic and social costs

Problems caused by unemployment occur across a country but are often very bad and deep-rooted in local and regional communities and within particular groups of society for example in the UK, more than one in six young people are out of work. The figure is much higher in Greece and Spain.

Measuring unemployment

TheClaimant Countmeasure includes people who are eligible to claim the Job Seeker's Allowance (JSA). The data is seasonally adjusted to take into account predictable seasonal changes in the demand for labour.

TheLabour Force Surveycounts those who are without any kind of job including part time work but who have looked for work in the past month and are able to start work immediately. The figure includes those people who have found a job and are waiting to start in the next two weeks.

On average, the labour force survey measure has exceeded the claimant count by about 500,000 in recent years. Because it is asurvey- albeit a large one and one that provides a rich source of data on the employment status of thousands of households across the UK - there will always be asampling error in the data.

The Labour Force Survey uses the internationally agreed definition of unemployment and therefore best allows cross-country comparisons of unemployment levels among developed countries.

Are we measuring unemployment accurately?

1 / Discouraged workers

No measure of unemployment is ever completely accurate since there are some people out of work but looking for a job who are not picked up by the official statistics

Official unemployment data misses out the hidden unemployed - an example arediscouraged workerswho have been out of work for a long time and who have stopped applying forjobs2 / economically inactive people who arenot actively looking for work some of the reasons include:

The need to look after elderly or infirmed relatives

Parents who are full-time carers for their children

People who have taken early retirement

3 / Under-employment:In many countries data may ignore the extent ofunder-employment, for example people who want full-time work but have to settle for a part-time job. In many lower-income countries the quality of the labour market data may be poor causing published figures to be inaccurate.

There are big differences in unemployment rates across the UK why do you think some regions suffer from persistently higher jobless problems?

Types and Causes of Unemployment

Frictional Unemployment

Frictional unemployment istransitional unemploymentas people move between jobs: For example, newly-redundant workers or people joining the labour market for the first time such as university graduates may take time searching to find work they want at wage rates they are prepared to accept.

Imperfect informationin the labour market may make frictional unemployment worse if the jobless are unaware of the available jobs.

Incentives problemscan also cause frictional unemployment as some people may stay out of work if they believe the tax and benefit system leaves them little or no better off from taking a job

When there aredisincentivesfor people to accept work, this is known as theunemployment trap.

Frictional unemployment happens when it takes time for a countrys labour market to match the available jobs with people seeking work. The chart below shows the monthly level ofunfilled vacanciesin the UK. For most of the current decade there have been between 500,000 and 700,000 unfilled vacancies.

The recession caused a steep decline in the number of available jobs and by the summer of 2010 there were fewer than 500,000 unfilled posts set against a much larger pool of unemployed. The result is that the ratio of unemployed to job vacancies has grown, meaning that there are many people chasing each available job. This makes it tough to get back into paid work.

Structural Unemployment

Structural unemployment happens when there is along-term decline in demand in an industryleading to fewer jobs being available as the demand for labour falls away this leads to a decline in employment in a particular industry (sector) or a particular occupation. Examples might include:

Jobs on a production line being replaced by robots e.g. motor manufacturing

Unemployment caused by foreign competition (or changes in comparative advantage)

Structural unemployment exists where there is amismatchbetween their skills and the requirements of the new job opportunities. This problem is due tooccupational and geographical immobility of labourand requires investment to improve skills, give the unemployed suitable training and work experience and make them able to move location if needed to take a new job.

Globalisationinevitably leads to changes in the patterns of trade between countries. Britain has probably now lost a cost advantage inmanufacturinggoods such as motor cars, household goods and audio-visual equipment, indeed our manufacturing industry has lost jobs as some production has shifted to lower-cost centres in Eastern Europe and emerging market countries in Far East Asia.

Many of these workers may suffer from a period of structural unemployment, particularly if they are in regions of above-average unemployment rates where job opportunities are scarce.

Employment in UK manufacturing industries has fallen year on year for nearly three decades. Since the turn of the century, over 1.5 million jobs have been lost in the manufacturing sector the decline was amplified by the effects of recession in 2008-2010 although there are tentative signs that manufacturing employment, investment and employment may now be picking up.

Jobs lost in manufacturing and construction creates problems of structural unemployment, but this is a cause of unemployment that can affect people in all sectors of the economy.

Cyclical Unemployment:

Cyclical unemployment isinvoluntary unemploymentdue to a lack of demand for goods and services. This is also known asKeynesian unemploymentordemand-deficient unemployment

When there is a recession or a steep slowdown in growth, we see a rising unemployment because of plant closures, business failures and an increase in worker lay-offs and redundancies. This is due to a fall in demand leading to a contraction in output across many industries.

Firms are likely to reduce employment to cut costs and/or maintain profits this is called labour shedding or down-sizing

The economy does not have to go into recession for cyclical unemployment to start rising. Many jobs can be lost even in a slowdown phase and one reason for this is because of risingproductivity. Say for example that a countrys GDP is expanding at 1 per cent a year but output per worker is growing by 3 per cent. This means that the same national output can be produced using fewer workers.

Inflation

Inflationis asustained increase in the cost of living or the average / general price levelleading to a fall in thepurchasing power of money.

The opposite of inflation is deflation which is a decrease in the cost of living or average price level.

How is the rate of inflation measured?

Therate of inflationis measured by the annual percentage change in consumer prices.

The British government has set aninflation targetof 2% using theconsumer price index(CPI)

It is the job of theBank of Englandto set interest rates so that aggregate demand is controlled, inflationary pressures are subdued and the inflation target is reached

The Bank is independent of the government with control of interest rates and it is free from political intervention.The Bank is also concerned to avoidprice deflation we return to this a little later.

Falling inflation does not mean falling prices!

Please remember that afall in the rate of inflationis not the same thing as afall in prices! Have a look at the chart above which measures the rate of consumer price inflation for the UK. Notice how in 2009 there was a steep drop in inflation from 5 per cent to 1 per cent over the course of the year. Inflation was falling but the rate remained positive meaning that prices were rising but at a slower rate! A slowdown in inflation is not the same as deflation! For this to happen, inflation would have to be negative.How is the rate of inflation calculated?

Thecost of livingis a measure of changes in the average cost of buying a basket of different goods and services for a typical household

In the UK there are two measures, theRetail Price Index(RPI) & theConsumer Price Index(CPI).

The major difference between the two measures, is that CPI calculations excludes payments on mortgage interest - it is thought that by excluding mortgages, the CPI is a better measure of the impact of macroeconomic policy

The CPI is aweighted price index. Changes in weights reflect shifts in the spending patterns of households in the British economy as measured by the Family Expenditure Survey.

The price index for this year is:the sum of (price x weight) / sum of the weights

So the price index for this year is 104.1 (rounding to one decimal place)

The rate of inflation is the % change in the price index from one year to another.

So if in one year the price index is 104.1 and a year later the price index has risen to 112.5, then the annual rate of inflation = (112.5 104.1) divided by 104.1 x 100. Thus the rate of inflation = 8.07%.

Limitations of the Consumer Price Index as a measure of inflation

The CPI is not fully representative:

Since the CPI represents the expenditure of the average household, inevitably it will be inaccurate for the non-typical household, for example, 14% of the index is devoted to motoring expenses - inapplicable for non-car owners.

Single people have different spending patterns from households that include children, young from old, male from female, rich from poor and minority groups.

We all have our own weighting for goods and services that does not coincide with that assigned for the consumer price index.

Housing costs:The housing category of the CPI records changes in the costs of rents, property and insurance, repairs. It accounts for around 16% of the index. Housing costs vary greatly from person to person.

Changing quality of goods and services: Although the price of a good or service may rise, this may also be accompanied by an improvement in quality as the product. It is hard to make price comparisons of, for example, electrical goods over the last 20 years because new audio-visual equipment is so different from its predecessors. In this respect, the CPI may over-estimate inflation. The CPI is slow to respond to the emergence of new products and services.

Our chart above illustrates sub-sections of the UK consumer price index. The base year for the calculation is 2005 so prices in January 2005 are given an index number of 100. Since then overall the consumer price index has increased by nearly 24% but energy prices (e.g. electricity and gas bills) have jumped by much more whereas there has been persistent and deep deflation in the prices of many audio-visual products.

Deflation

Price deflationhappens when therate of inflation becomes negative. I.e. the general price level is falling and the purchasing power of say 1,000 in cash is increasing

Some countries have experienced periods of deflation in recent years; perhaps the most well-known example was Japan during the late 1990s and in the current decade. In Japan, the root cause of deflation was slow growth and ahigh level of spare capacitythat was driving prices lower.

Hyperinflation

Hyperinflationis extremely rare. Recent examples include YugoslaviaArgentina,Brazil,GeorgiaandTurkey(where inflation reached 70% in 1999)

The classic example of hyperinflation was therampant inflation in Weimar Germany between 1921 and 1923.

When hyperinflation occurs, the value of money becomes worthless and people lose all confidence in money both as astore of valueand also as amedium of exchange

Therecent hyperinflation in Zimbabweis a good example of the havoc that can be caused when price inflation spirals out of control. It has made it virtually impossible for businesses to function in any kind of normal way.

For Britain the worst inflation experienced in modern times was during themid to late 1970swhen prices were rising at an annual rate of over twenty per cent. At the same time the economy was suffering from slow growth and rising unemployment and this gave rise to the idea ofstagflation.

Understanding the main causes of inflation

Inflation can come from both thedemandand thesupply-sideof an economy

Inflation can arise frominternalandexternalevents

Some inflationary pressures direct from thedomestic economy, for example the decisions of utility businesses providing electricity or gas or water on their tariffs for the year ahead, or the pricing strategies of the food retailers based on the strength of demand and competitive pressure in their markets.

A rise in the rate of VAT would also be a cause of increased domestic inflation in the short term because it increases a firms production costs.

Inflation can also come fromexternal sources, for example a sustained rise in the price of crude oil or other imported commodities, foodstuffs and beverages.

Fluctuations in the exchange ratecan also affect inflation for example a fall in the value of the pound against other currencies might causehigher import pricesfor items such as foodstuffs from Western Europe or technology supplies from the United States which feeds through directly or indirectly into the consumer price index.

Demand-Pull Inflation

Demand pull inflation occurs when aggregate demand is growing at an unsustainable rate leading toincreased pressure on scarce resourcesand apositive output gap

When there isexcess demand, producers are able to raise their prices and achieve biggerprofit marginsbecause demand is running ahead of supply

Demand-pull inflation becomes a threat when an economy has experienced a boom withGDPrising faster than the long-run trend growth of potential GDP

Demand-pull inflation is likely when there isfull employment of resourcesand SRAS is inelastic

Main Causes of Demand-Pull Inflation

Adepreciationof the exchange rateincreases the price of imports and reduces the foreign price of a countrys exports. If consumers buy fewer imports, while exports grow, AD in will rise and there may be amultiplier effecton the level of demand and output

Higher demand from afiscal stimuluse.g. lower direct or indirect taxes or higher government spending. If direct taxes are reduced, consumers have more disposable income causing demand to rise. Higher government spending and increased borrowing creates extra demand in the circular flow

Monetary stimulus to the economy:A fall in interest rates may stimulate too much demand for example in raising demand for loans or in leading to house price inflation. Monetarist economists believe that inflation is caused by too much money chasing too few goods and that governments can lose control of inflation if they allow the financial system to expand the money supply too quickly.

Fast growth in other countries providing a boost to UK exports overseas. Export sales provide an extra flow of income and spending into the UK circular flow so what is happening to the economic cycles of other countries definitely affects the UK

Cost-Push Inflation

Cost-push inflation occurs when firms respond torising costs, by increasing prices toprotect their profit margins.

There are many reasons why costs might rise:

Component costs:e.g. an increase in the prices of raw materials and other components. This might be because of a rise in commodity prices such as oil, copper and agricultural products used in food processing. A recent example has been a surge in the world price of wheat.

Rising labour costs- caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low because skilled workers become scarce and this can drive pay levels higher. Wages might increase when peopleexpect higher inflationso they ask for more pay in order to protect their real incomes. Trade unions may use their bargaining power to bid for and achieve increasing wages, this could be a cause of cost-push inflation

Expectationsof inflationare important in shaping what actually happens to inflation. When people see prices are rising for everyday items they get concerned about the effects of inflation on their real standard of living. One of the dangers of a pick-up in inflation is what theBank of Englandcalls second-round effects i.e. an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life. This is also known as a wage-price effect

Higher indirect taxes for example a rise in the duty on alcohol, fuels and cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers.

A fall in the exchange rate this can cause cost push inflation because it leads to an increase in the prices of imported products such as essential raw materials, components and finished products

Monopoly employers/profit-push inflation where dominants firms in a market use their market power (at whatever level of demand) to increase prices well above costs

Cost-push inflation such as that caused by a large and persistent rise in the world price of crude oil can be shown in a diagram by aninward shift of the short run aggregate supply curve. The fall in SRAS leads to a contraction of national output together with a rise in the level of prices. This is shown in the next diagram.

What are some of the main consequences of inflation?

"The lesson of the past fifty years is that, when inflation becomes embedded, the cost of getting it back down again is a prolonged period of sluggish output and high unemployment. Price stability returning inflation to the target is a precondition for sustained growth."Source: Mervyn King, Governor of the Bank of England, Mansion House speech, June 2008

Many government s have atarget for a low but positive rate of inflation. They believe that persistently high inflation can have damaging economic and social consequences.

Income redistribution: One risk of higher inflation is that it has aregressive effecton lower-income families and older people in society. This happen when prices for food and domestic utilities such as water and heating rises at a rapid rate.

Falling real incomes: With millions of people facing a cut in their wages or at best a pay freeze, rising inflation leads to a fall in real incomes.

Negative real interest rates: If interest rates on savings accounts are lower than inflation, people who rely on interest from their savings will be poorer. Real interest rates for millions of savers have been negative for at least four years

Cost of borrowing: High inflation may also lead to higher interest rates for businesses and people needing loans and mortgages as financial markets protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt. There is also pressure on the government to increase the value of the state pension and unemployment benefits and other welfare payments as the cost of living climbs higher.

Risks of wage inflation: High inflation can lead to an increase in pay claims as people look to protect their real incomes. This can lead to a rise in unit labour costs and lower profits for businesses

Business competitiveness:If one country has a much higher rate of inflation than others for a considerable period of time, this will make its exports less price competitive in world markets. Eventually this may show through in reduced export orders, lower profits and fewer jobs, and also in a worsening of a countrys trade balance. A fall in exports can trigger negative multiplier and accelerator effects on national income and employment.

Business uncertainty: High and volatile inflation is not good for business confidence partly because they cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a lower level of capital investment spending.

High and volatile inflation can have serious economic and social consequences summarized below

Why is the rate of inflation difficult to forecast accurately?

The rate of inflation is one of the most important macroeconomic indicators that we study in macroeconomics. Data on prices is published regularly and given lots of attention by the media and the financial markets. Many agents be they businesses, households and governments would like to have accurate forecasts of what is likely to happen to prices in the future because they affect spending, saving and investment decisions.

Inflation is a difficult indicator to forecast accurately. Our chart below shows the UK CPI inflation forecast published by the Bank of England in their quarterly Inflation Report. Remember that the Bank of England has a mandate to control the rate of inflation so that CPI inflation remains close to the 2% target. The probability fan chart for inflation indicates the range of probabilities for inflation in the forecast period. Notice how wide is that range, there is much uncertainty about what is likely to happen to inflation in the UK. In 2014, there is the possibility of deflation (inflation of -1%) or inflation higher than 4%. The darker the shading, the higher the probability attached to the outcome.

Some reasons for difficulties in forecasting inflation

The Banks Inflation TargetIn order to maintain price stability, the Government has set the Banks Monetary PolicyCommittee (MPC) a target for the annual inflation rate of the Consumer Prices Index of 2%. Subject to that, the MPC is also required to support the Governments objective of maintaining high and stable growth and employmentControlling inflation macroeconomic policies

Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the rate of growth of aggregate supply (AS)

Fiscal policy:

a. Controlling aggregate demand is important if inflation is to be controlled. If the government believes that AD is too high, it may choose to tighten fiscal policy by reducing its own spending on public and merit goods or welfare payments

b. It can choose to raise direct taxes, leading to a reduction in real disposable income

c. The consequence may be that demand and output are lower which has a negative effect on jobs and real economic growth in the short-term

Monetary policy:

a. A tightening of monetary policyinvolves the central bank introducing a period of higher interest rates to reduce consumer and investment spending

b. Higher interest rates may cause theexchange rateto appreciate in value bringing about a fall in the cost of imported goods and services and also a fall in demand for exports (X)

Supply side economic policies:

a. Supply side policies seek to increaseproductivity,competitionandinnovation all of which can maintain lower prices. These are ways of controlling inflation in the medium term

A reduction in company taxes to encourage greater investment

A reduction in taxes which increases risk-taking and incentives to work a cut in income taxes can be considered both a fiscal and a supply-side policy

Policies to open a market to more competition to increase supply and lower prices

b. Rising productivity will cause an outward shift of aggregate supply

4. Direct controls - a government might choose to introduce direct controls on some prices and wages

b. Public sector pay awards the annual increase in government sector pay might be tightly controlled or even froze (this means a real wage decrease).

c. The prices of some utilities such as water bills are subject to regulatory control if the price capping regime changes, this can have a short-term effect on the rate of inflation

Evaluation points how best can inflation be controlled?

The most appropriate way to control inflation in the short term is for the government and the central bank to keep control of aggregate demand to a level consistent with our productive capacity

AD is probably better controlled through the use of monetary policy rather than an over-reliance on using fiscal policy as an instrument ofdemand-management

Controlling demand to limit inflation is likely to be ineffective in the short run if the main causes are due to external shocks such as high world food and energy prices

The UK is an open economy in which inflation is strongly affected by events in the rest of the world

In the long run, it is the growth of a countryssupply-sideproductive potential that gives an economy the flexibility to grow without suffering from acceleration in cost and price inflation.

UNIT 2

Prepared By: A.LavanyaPage 13